Add-on goods and contingent charges.

How behavioural economics has affected the

regulation of Overdraft and Payment Protection Insurance markets.

1. Introduction

How does behavioural economics affect financial regulation? This question is explored in the

context of the UK retail banking sector. Specifically the paper reviews the influence of add-on

goods theories (e.g. Ellison, 2004; Gabaix and Laibson, 2006) and contingent charges (e.g.

DellaVigna and Maldendier, 2004; Piccione and Spiegler, 2012; Shapiro, 1995) on the regulation

of two touchstone retail banking markets; the overdraft and payment protection insurance

(hereafter termed PPI and also termed credit insurance in the USA)1. It is reported developments

in the theory of add-on markets and contingent charging has influenced regulation in these

markets.

Regulatory actions within the PPI market addressed concerns with how this service was

distributed, through banning joint sales within seven days of the associated credit agreement (CC,

2009). Distinctly the regulation of overdrafts and the associated personal current accounts have

viewed overdrafts to be an intrinsic element of a product bundle rather than an add-on good.

Subsequently regulatory actions have addressed the symptoms arising from an add-on markets

rather than the causes of this customer harm. While both markets have witnessed a large decline

in profitability after regulatory interventions, the overdraft market has continued growing in clear

contrast to PPI markets which has declined in scale substantially.

It is concluded the dynamic and fragmented regulatory structure, multiple policy agendas and a

successful legal intervention have all influenced how these financial services markets have been

regulated and reduced the potency of behavioural economic concepts. In particular aspects of

overdraft markets remain challenging to address including the ability to exclude competition from

aftermarkets.

1
The application of behavioural economics within financial regulation is important for many

reasons; not least retail banking has undergone a tumultuous decade. From being at the forefront

of economic development and inclusion, public perceptions of banking have been transformed.

This industry has passed through both systemic crisis and repeated scandal shattering public trust

in this industry. These concerns have been particularly acute in the UK where a bank run was

observed for the first time in over a century (Shin, 2009) and mis-selling scandals have led to

astronomical levels of redress2. While these shifts in perception have been driven primarily by the

global banking crisis in 2007-8, this jaundiced viewpoint of the banking industry owes much to

how banks have distributed products and charged customers. A significant driver of this process

has been the ascent of behavioural economics and the dissemination of these concepts amongst

financial regulators (see Erta et al, 2014).

Understanding how add-on good markets and contingent charges operate has been particularly

important in this development. While examples of add-on goods and contingent charges as diverse

as hotel minibar pricing, gym memberships, dry cleaning and car rentals have been discussed in

the literature, retail banking is a key area in which add-on goods and contingent pricing are believed

to exist. The provision of retail banking services has provided one of the most commonly used

examples of how behavioural economic models of add-on goods and contingent charging operate

(e.g. DellaVigna and Malmendier, 2004; Ellison, 2004; Gabiax and Laibson, 2006; Piccione and

Spiegler, 2012). Clearly retail banking is a prime candidate to examine how behavioural economics

has influenced regulation and practice within the market place.

Turning to the contribution of this work, is important not to replicate materials already considered

in one of the many reviews of behavioural economics seen in recent years. Behavioural economics

review articles have appeared on an assortment of topics including economics and psychology

(DellaVigna, 2009), the psychology behind financial crises (Garling et al, 2009), behavioural

economics and credit (Elliehausen, 2010), behavioural economics applied to firms (Armstrong and

2
Huck 2010), consumer behavioural biases in competition (Huck and Zhou, 2011), behavioural

economics and marketing (Chuah and Devlin, 2011), behavioural economics and financial literacy

(Altman 2012), behavioural economics in financial regulation, (Erta et al, 2013), herding in financial

markets (Spyrou, 2013), contrarian and momentum trading (Galariotis, 2014), behavioural

concerns in pricing (Grubb, 2015) and behavioural finance and associated experimental evidence

(Duxbury, 2015a and 2015b). Moreover much of the theoretical development of this subject has

been reviewed within textbooks (notably Spiegler, 2011). This paper therefore contributes by

examining a currently under-researched aspect of behavioural economics; how theoretical insights

have influenced market regulation.

To address this question the paper is structured as follows. After this introduction the theoretical

developments of add-on markets and contingent charging are briefly outlined. The literatures

surrounding the overdraft and PPI markets are then summarised. In section four, regulatory

reporting in these markets is reviewed before conclusions are drawn in the final section.

2. Add-on goods - theory

Examining how prices are formed and markets are organised are prominent matters within

economics. Despite this importance, situations where primary markets for base goods are observed

in combination with aftermarkets for add-on or contingent goods was an overlooked concern for

many years. Historically markets were viewed to operate and establish prices independently with

traditional market analysis focusing on the supply side concerns, examining how markets were

organised under different information and technological assumptions and frequently assuming

customers behave rationally (see Huck and Zhou, 2011). This disregarded situations where

behavioural biases might influence competition and distort customer demands. Remedying this

3
situation has been at the heart of a flourishing literature assessing the market interaction between

profit maximising firms and boundedly rational consumers.

Add-on goods and contingent charges influence how customers search for appropriate products

and whether the customer obtains an appropriate service or pays a reasonable or excessive price

for these services. In order to make an appropriate financial service purchase individuals might be

expected to have a clear understanding of the financial services characteristics, how their own

preferences relate to these characteristics and their future demands for this service. Despite these

expectations many consumers have a poor comprehension of financial services (Bucks and Pence,

2008) particularly the young, old and less wealthy (Agarwal et al 2009). When consumers decision

making deviates from assumed perfect rationality, this can become a source of oligopoly power

(Scitovsky, 1950). This power arises when customers pay too much for a good or service,

overconsume a service, misjudge prices, buy an ill-suited or inferior quality product or stay with

their current supplier excessively. These circumstances whilst favourable to firms, can punish

customers and result in considerable allocative inefficiencies and waste. Add-on goods and

contingent charging are techniques creating such challenges for customers and opportunities for

firms.

Within add-on goods markets, a base good of interest to the customer is offered in a primary

market together with another add-on good offered within an aftermarket. As the customer is

actively searching for the base good or service, the primary market may witness competition in

price and quality differences. The aftermarkets where add-on goods are sold may display different

competitive conditions. As the conditions of sale of an add-on goods may not be clear, some

customers may undertake a purchase decision for an add-on service without realising the costs of

this action or unsure as to their needs for this purchase.

4
In such a situation, price competition in aftermarkets can be constrained and higher prices develop.

The extent to which prices may rise is constrained by a range of factors. If it is easy for a customer

to observe the high costs of an add-on service, to switch to an alternative supplier or cancel the

add-on good, prices of these additional goods can be constrained. Similarly, if customers

comprehend their demands for the add-on goods, poor decisions may be avoided. Lastly, if firms

are unable to exclude other firms from aftermarkets, competition may develop within associated

independent markets.

Cognisant of this information, firms may frame the purchase decision and adjust how primary and

add-on goods are distributed to overcome these constraints on profitability, facilitating customers

over or under estimating their demands and leading to overpayment or excessive use of a service

(see Huck and Zhou 2011). This may occur through the design of the contingent charges

associated with using the add-on service (DellaVigna and Malmendier, 2004). Contracts may also

be adjusted to make switching more challenging. The comprehension of the add-on goods utility,

quality and cost may all be obscured using complex pricing formats and small print (Piccione and

Spiegler, 2012; Sato, 2014). Indeed within overdraft markets overdraft charges have been arranged

in a manner to encourage customers to incur higher fees3. Lastly, the firm could place the add-on

good at the heart of a bundled product, making this service intrinsic to the provision of the primary

good and challenging for other firms to contest in this aftermarket. These outcomes will all make

aftermarkets more profitable than primary markets. To gain market share firms may cross-

subsidise primary markets from aftermarket profits, attracting more customers to the primary

market and creating more opportunity to cross-sell add-on goods (Gabaix and Laibson, 2006).

Further discussion of the development of the theoretical literature is provided by Huck and Zhou,

2011; Spiegler, 2011).

5
Such an application is observed for the overdraft markets. Armstrong and Vickers (2012) examine

the pricing of overdrafts theoretically, viewing these services as a tied aftermarket and

complimentary yet distinct to the base service. This model assumes customers have differing

decision making abilities. Some customers are nave customers and choose the lowest costs of

primary personal current account services (deposits and payment service prices) whilst the diligent

customers, who can take actions avoid high charges, chose the lowest overall costs (deposit,

payment services and overdrafts). If there are enough diligent customers or low enough contingent

charges then efficient contract terms will develop. Alternatively if there are enough nave

customers and contingent charges are high then the aftermarket profits could subsidise the base

good. Firms will then compete more for the initial purchase with subsequent profits passed back

to the customer in the form of subsidised base good. This may lead to an inefficient pattern of

pricing, redistributing costs from customers using overdrafts to those customers using these

services.

For the case of PPI we observe a similar process developing. This type of add on insurance service

is not compelling for many customers to purchase and is offered with the base product of interest,

credit. To overcome disinterest in PPI, sales staff are incentivised to encourage customers to

purchase PPI due to its high profitability and benefit to banks. PPI could be aggressively marketed

yet more commonly has been sold assumptively and through emotional appeals to risk averse

customers (see Ranyard and McHugh, 2012b). The high profits derived from PPI may then

subsidise the associated credit market to attract more customers 4, who are encouraged to purchase

PPI. While some customers, cognisant of their demands for PPI will not purchase this service, if

there are enough customers which do not comprehend this service or can be persuaded to

purchase PPI, this sequence of circumstances will intensify overtime. In particular when sales staff

discover those customers least able to determine the utility of this service are the most susceptible

to assumptive or hard sell practices, high levels of mis-selling can arise.

6
In both these cases add-on good models predict inappropriate purchase decisions of expensive

and potential low quality services and excessive profits being derived over the long term without

regulatory intervention.

3. Overdraft and Payment Protection Insurance (PPI) Markets

To explore these theoretical developments we examine two markets which employ add-on

services: overdrafts and PPI. Both markets have been highly profitable and the focus of widespread

public unease and regulatory attention. Despite these similarities these products also differ;

functionally through serving distinct needs and by using differentiated distribution models.

Overdrafts are generally priced on a contingent basis depending on their use; PPI policies, be these

paid through single or regular premiums, are priced at the point of sale. These markets also vary

in the access provided to aftermarkets. Overdraft services are effectively closed to competitors

whilst borrowers have the option to obtain PPI from alternative providers.

3.1 The scope of these markets

During the last decade the retail banking business has been transformed. A major aspect of this

change has been the low interest rate environment and the associated decline in the profitability

of many core retail banking services. As interest rate margins have narrowed and previously

lucrative services produce lower returns; an increasing reliance on non-interest and fee based

income (Lepetit et al, 2008; Valverde and Fernndez, 2007) and questionable practices (Tennant

and Sutherland, 2014) has emerged. While these trends have been witnessed globally, concerns

have focused on two problematic markets in the UK; PPI and overdrafts.

7
Both these markets have been substantial sources of profits. Estimates of revenues from personal

current accounts and overdraft markets vary yet are substantial. The Competition and Markets

Authority (hereafter CMA) (2015) estimated there were 68 million active personal current accounts

generating revenues of 8.7 billion in 2014. Of these customers, 25.3 million used an overdraft

(39% of customers) generating 2.9 billion of revenues for authorised and unauthorised overdraft

providers in 2013; a figure equal to 115 for each personal current account customers which

incurred an overdraft in that year (CMA, 2014). These values have changed over the previous

decade; the OFT (2008) estimated 12 million UK customers used overdrafts producing revenues

of 8.63bn in 2006, displaying an increase in usage and decline in costs. These high costs of

overdraft provision are also observed internationally; for the USA, Parrish and Frank (2011)

reported consumers paid $23.7bn in overdraft fees in 2008; an increase of 35% since 2006

($17.5bn).

PPI markets have also been highly profitable. At its peak in 2006, the most common form of PPI

was for unsecured personal loans, accounting for 45% of the overall UK PPI market and valued

at 2,013m (CC, 2007). Mortgage PPI for first and second charge mortgages accounted for 24.9%

of the PPI market and was valued at 1,099m in 2006. This sector also expanded rapidly with

annual growth rates of between 15-20% for the 2000-2005 period (OFT, 2006) and is currently in

decline (CC, 2008). For example the take up of mortgage PPI on all new mortgage contracts has

also fallen from a high point of 24% in 2003 to 18% in 2007. For the USA, Baker and Siegelman

(2014) report in 2010 the credit life insurance market was worth $770m and the accident and health

credit insurance was valued at $875m. These values have also been declining over the previous

decade.

Lastly, overdrafts and PPI are two of three most mistrusted financial services markets of the last

decade. Considering data assembled from the 14 publically available annual reports of the UK

Financial Ombudsman Service, unresolved complaints raised by customers and forwarded to this

8
arbitration service between 2001-14 are recorded in Table 1. Whilst a complaint does not indicate

any firm wrong doing, it acts as a rough proxy for the concerns arising in different financial services

markets5. It is observed that PPI and personal current accounts have been the largest source of

complaints to the UK Financial Ombudsman service since 2008. Further the percentage of

complaints attributed to add-on goods (an imprecise measure due to the partial reporting of these

financial services) has increased dramatically from below 10% of complaints in the early 2000s to

over 80% of complaints in 2008. While acknowledging the imprecision of this measure, add-on

services appear to be a significant and growing public anxiety in financial services markets.

INSERT TABLE 1

3.2 Overdrafts

Overdraft lending provides a source of emergency capital or an ad hoc bridging loan for

accommodating short term liquidity concerns. This lending is contingent on customers actions

and is either agreed or authorised by the bank or unauthorised by a bank and accepted at the banks

discretion. Overdrafts are accessed after the primary good is purchased and are priced as part of

an entire bundle of financial services; the personal current account. Historically, overdraft lending

was considered an indulgence of the customer (Whitney, 1918) where fees are levied to cover the

costs of this lending and discouraging future undesirable customer behaviour.

The design of personal current accounts and overdraft charges has developed and varied greatly.

In the UK free banking forms of charging have been widely used since 19846, gaining most market

share by 2006 (OFT, 2008) and are increasingly observed in Australia, Ireland and the USA (see

Senate Economics References Committee, 2011; Central Bank of Ireland, 2012; Federal Deposit

Insurance Corporation, 2008). In free banking current accounts payment services are not directly

paid for by customers and are often assumed to be subsidised by customers using overdraft

9
services (Armstrong and Vickers, 2012) or personal current account deposits (see Ashton and

Hudson, 2013).

Despite the scale of personal current account provision, there is a scarcity of academic work. In

the UK past examinations of personal current accounts have generally addressed concerns other

than pricing, including the transmission of monetary policy (e.g. Heffernan, 2002) and personal

current account switching (e.g. Gondat-Larralde and Nier, 2006). In the USA these literatures have

been more extensive, originally examining pricing for personal current accounts (termed checking

accounts) for payment service use (Ederington and Skogstad, 1977; Mingo, 1980; Osborne and

Wendel, 1981) and assessing credit service demands (Bar-Ilan, 1990; Boyd, 1976; Morgan, 1978).

More recently this body of work has examined customer decision making using proprietary data

of personal current account use (e.g. Fusaro, 2008; Fusaro and Ericson, 2010; Stango and Zinman,

2009) and customer switching (Kiser, 2002). A limited number of studies have also been

undertaken in other nations including Canada (Seldon and Solmer, 1996) and the Netherlands

(Cuhna et al, 2011) examining the pricing of transactional and deposit services and demand for

credit respectively. Lastly, work predominantly from Scandinavia has assessed the costs of

payment services used within current accounts (for example Guibourg and Segendorff, 2007;

Humphrey et al, 2003). A legal review of UK bank overdraft fees and charges is provided by

Whittaker (2011).

3.3 Payment Protection Insurance (PPI)

PPI provides varying combinations of accident, sickness and unemployment insurance and is used

to protect the loan payments of policyholders in the event of losing their income. This financial

service, devised in 1917 (Baker and Siegelman, 2014) is unusual in that the amount insured declines

over the term of the policy and provides cover to both the borrower and lender. These outcomes

10
are attractive to many lenders (see Ashton and Hudson, 2012), reduce the probability of loan

default and may have freed banks to lend to customers previously red-lined and excluded from

credit markets (Ross and Tootell, 2004).

Past UK academic research considering PPI has focused on mortgage PPI. This literature has

examined the determinants of PPI take-up, perceptions of, and satisfaction with these products.

While some contributions have reported the decision to take out mortgage PPI is rational (Pryce,

2002), other survey evidence has indicated mortgage PPI is very expensive, limited in coverage and

has regressive elements (Burchardt and Hill, 1998). Other UK PPI markets have also been

investigated. For example, Ranyard and McHugh (2012a) examined customer decision making in

PPI markets generally, reporting the willingness to pay for PPI is insensitive to changes in the

quality of cover. Ashton and Hudson (2014) examined unsecured lending PPI and reported

interest rate setting of loans significantly reduced when loans were offered jointly with PPI. Lastly

Ranyard and McHugh (2012b) reported PPI can ameliorate perceptions of risk associated with

borrowing. Ferran (2012) provides a legal overview of the PPI mis-selling episode.

US academic assessments of PPI have focused on the sale of PPI (termed credit insurance), with

sales approaches and involuntary tying arrangements a primary concern. This emphasis arises from

the widespread use and high profitability of PPI in the USA. Early survey evidence indicated most

customers do not perceive sales to be coercive yet felt obliged to purchase PPI (Polden, 1983).

Durkin (2002) indicated cross selling lends itself to coercive sales and PPI sales have focused on

older and lower socio-economic groups (Barron and Staten, 1995). Similarly, Lecko and

Pappalardo (2007) identified a substantial proportion of customers had difficulties in determining

whether credit deals actually included PPI and other extra product features. Other US

contributions have emphasised the limited competitiveness of mortgage PPI markets, overpriced

policies, excessive coverage provided (Cyrnak and Canner, 1986) and the small quantities insured

11
(Durkin and Elliehausen, 2012). Discussion of on-going policy issues in US PPI markets is

provided by Baker and Siegelman (2014).

4. The Regulatory Treatment of PPI and Overdraft markets in the UK.

The overdraft and PPI markets have both been the subject of extensive regulatory examination in

the UK during the last decade. This is summarised in Tables 2 and 3 for the overdraft and PPI

markets respectively. In both markets current and past regulators have contributed to the

assessment of these markets. These include financial regulators such as the now defunct Financial

Services Authority (hereafter FSA) and the new financial regulator, the Financial Conduct

Authority (hereafter FCA). These regulators empowered by financial markets and services

legislation have undertaken actions including enforcement of regulations and regulatory reporting

of entire markets. Competition law and consumer protection regulators have also been involved

with the investigation and subsequent regulation of these markets. These regulators empowered

under competition and enterprise laws have undertaken markets reports and legal proceedings.

These regulators include the now defunct consumer protection body, the Office of Fair Trading

(hereafter OFT) and the competition law enforcement body, the Competition Commission

(hereafter CC). These regulators have since been merged to form the Competition and Markets

Authority (hereafter CMA). There are also general reports commissioned by the UK finance

ministry or parliament to confront increasing public concerns within banking markets (e,g

Cruickshank report, 2000; HM Treasury Committee, 2010; Independent Commission on Banking,

2011). Lastly for PPI EU nascent regulation has appeared.

In considering the findings from Tables 2 and 3 it is striking how prolonged these processes of

regulatory intervention have become, with many regulatory reports providing repetitive findings

for these markets. Through examining these commonalities and differences observed within this

regulatory reporting, a range of insights are drawn. Initially it is apparent differing regulatory

agendas exist within UK financial and competition regulation. These include persistent concerns

12
with financial exclusion and customer responsibility, inert customers, pricing and product

complexity and the treatment of less affluent. These often conflicting priorities may have

complicated decision making during these regulatory processes.

For both markets there have been neoliberal (see Moloney, 2010) anxieties that financial services

is disseminated widely to limit financial exclusion, enable informed consumers to partake in these

financial markets allow consumers to take responsibility for their own financial dealings (FSA,

2008) and provide a degree of competitive market discipline for the incumbent firms. Within the

overdraft market, concerns arise that all persons need access to personal current account services

to benefit from a monetarised economy and that high overdraft fees and charges may be restraining

this process. In the PPI market the government support of mortgagees has been phased out (see

Ford and Quilgars, 2001) and new forms of loan protection such as PPI are required ((Department

for Environment, Transport and the Regions, 2000).

The regulatory reports also persistently elaborate situations where customers are inert. In overdraft

and personal current accounts, customers do not switch their personal current account supplier or

sufficiently track the market offerings. UK customers switching personal current account has fallen

over time from 6% in 2006 (OFT, 2008), to 3.8% in 2010 (Independent Commission on Banking,

2011) and to 3% in 2014 (CMA, 2015). In PPI markets despite having access to both independently

and jointly distributed PPI policies, customers have persistently opted to purchase PPI from their

credit supplier. The point of sale advantage led to around 80% of all PPI to be sold in combination

with credit services (OFT, 2006). Some firms have also faced fines and public censure for

amplifying this inertia through selling PPI assumptively and encouraging consumers to view joint

distribution as a normal practice. Indeed most customers were reported to focus predominantly

on the interest rate of the loan and felt taking out PPI would help their credit application (OFT,

2006).

13
A distinct consumer protection agenda has also developed in PPI and overdraft regulatory

reporting indicating customers can be unaware of the characteristics and costs of the service they

have purchased, may be confused as to how prices are established and perplexed by usual forms

of product distribution. Within overdraft markets there are continuing concerns that free banking

and packaged accounts remain confusing for customers and may not lead to informed decisions

as to use overdraft services or otherwise. It is persistently reported the variety of contingent

charges in this market has limited product comparison, restrained switching activity and made

control over overdraft use and subsequent charges arduous for some. For example the OFT (2008)

reported over a fifth of consumers were unaware of insufficient funds charges until they had

incurred such a charge. Such limited customer attentiveness has led to discussion as to how to

inform customers they are incurring fees. These actions have included the ability for customers to

opt out of unauthorised overdrafts (see OFT, 2011, 2013) and/or receive text alerts, warning

consumers they have performed a transaction which may result in charges being levied (OFT,

2009).

For PPI similar concerns have arisen, yet reflecting the different market circumstances. Over 93%

of UK PPI for unsecured lending used a single premium for the duration paid at the start of the

loan period (CC, 2008b), a practices which made it difficult for customers to learn through

repeated purchase experience. The high levels of commission paid to PPI distributors have also

been a competitive impediment (59% of premiums are paid in commissions, OFT, 2006). Further

repeated regulatory reports have questioned the link between policy attributes and the potential

pay-out from such policies, reporting that many policies are overpriced and of poor quality. For

instance the OFT (2006) reported PPI claims paid as a percentage of gross written premium was

18% relative to a comparable figure of 84% for car insurance over the same period (CC, 2008b).

A last common theme running through these reports has been a concern that the less affluent and

least able to navigate these markets may be suffering unduly. Within the overdraft markets some

14
commentators (e.g. OFT, 2008) have speculated distributional cross-subsidies exist, in a Reverse

Robin Hood form (see Mullineux, 2009). Similarly within PPI markets there has been repeated

concerns that those purchasing PPI have been associated with lower levels of education, lower

social class and have tended to be younger and older customers (e,g. CC, 2007).

Turning to the differences between the regulatory reporting for these markets; many differences

are observed. The overdrafts reports have persistently emphasised the importance of traditional

forms of economic analysis. This includes a continuing focus on market concentration as an

explanation for the markets ills, rather than embracing concepts of add-on goods and product

distribution as the primary cause of excessive profits and customer harm. Further, while the

examination of the PPI market has been mostly concluded the regulatory examination of the UK

overdraft market is on-going; a situation not least resulting from the legal intervention into this

case.

The importance of the legal appeal in the overdraft judgement by the banks also has been

significant. Legal action ensued as to the fairness of unauthorised overdraft charges with a case

between the OFT and seven banks leading to rulings that bank overdraft charges are unfair by the

High Court and the Appeal Court before eventually being rejected by the Supreme Court in 2009

(see Whittaker, 2011). Crucially this final judgement viewed overdraft services to be an integrated

part of the pricing of personal current account services and not an exceptional or incidental add-

on cost; a situation where the unfairness or otherwise of a particularly charge cannot be

determined. Amongst other arguments, this judgement assumed the scale of income derived from

overdraft contingent charges was so substantial it must be an essential part of the service bundle.

It is important to note this ruling was made without reference to empirical investigation and can

be applied to other markets where contingent charges are employed. In particular the implication

that customers must read all clauses to be aware of harmful contingencies is of concern for future

regulation of add-on markets.

15
This outcome contrasts with the PPI case where the regulatory outcome focused far more on

amending the add-on good market structure. The CC (2009) ruled joint sales of PPI with loans

should be prohibited within seven days of the credit agreement. The form of distribution was

deemed to be crucial to the concerns with excessive profits and consumer harm observed in this

market. Further premiums should be paid through instalments rather than as a single premium to

enhance customer learning in these markets, improved customer information was required and

needed to be provided and PPI should be unbundled from other financial services (CC, 2009).

Moreover a process of customer redress was initiated and remains on-going for mis-sold PPI (see

FSA, 2009; FCA, 2014).

INSERT TABLES 2 & 3

5. Conclusions

In this paper we have examined and reviewed the application of behavioural economic theories of

add-on goods and contingent charges within two markets: overdrafts and PPI. Through a

discussion of these markets and a review of the UK regulatory reporting, a number of insights are

drawn. A primary conclusion is that the regulatory process for PPI embraced and applied the

insights of behavioural economics far more than observed in the overdraft market. While there

was extensive mis-selling of PPI, this appears to be addressed through regulatory intervention,

resulting in the decline of this market. In the overdrafts market regulatory reporting has examined

features and symptoms of add-on goods, yet not amended the forms of distribution underlying

these concerns. Certainly the profitability of overdrafts has been diminished and constrained by

the array of regulatory measures. While some of these measures, such as enhancing financial

literacy may be of questionable value (see Gu and Wenzel, 2014) other regulatory actions have had

an undoubted positive impact. Further, successes have been observed for tangential policy aims

including public engagement with the personal current account market. Despite these

16
achievements, competitive and customer concerns persist within the overdraft market and have

not been fully addressed.

Why has this difference occurred? These different regulatory responses have emerged due to

different neoliberal and consumer protection regulatory agendas employed by different regulators

at different times. These have allowed potentially conflicting requirements to develop; a not

implausible claim in light of the fragmented and dynamic regulatory structures overseeing these

markets. This is particularly acute in personal current account markets where deposits, payment

services and overdrafts, all part of a personal current accounts have had different and changing

regulators. Deposit or banking elements are currently regulated by the FCA and were regulated by

the FSA. The credit element of overdrafts was regulated by the OFT, the payments system

considered by the Payments Council and allied competition issues addressed by the OFT and the

CC and then the CMA. This has at least resulted in substantial repetition within regulatory

reporting.

Lastly, throughout these regulatory processes, it was accepted PPI was an add-on good and

overdrafts are not. This owes much to the Supreme Court ruling (2009, see Whittaker 2011) on

unauthorised overdraft charges. It was assumed PPI is distributed as an optional extra which a

customer chooses to purchase at the point of sale, while overdrafts are distinct and viewed to be

an integral aspect of the product bundle, the personal current account. Clearly overdraft providers

have navigated the law more successfully in reaching this consensus. Subsequently we should

recognise financial regulation can form as much as a political compromise between competing

constituents as a reflection of technical and economic concerns. Economic psychology has been

important in these regulatory cases yet on occasion it can be legally and politically appealing to

treat the symptoms of a problem rather than the cause itself.

17
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23
Table 1 Complaints received by the UK Financial Ombudsman Service 2001-2014 by product area.
(% of annual complaints received) Compiled from Annual Reports of the UK Financial Ombudsman Service.

Whole-of-
Investment- % add-
Credit Motor Mortgage life policies Total
Year PPI PCA Mortgages Pensions linked Other on
cards insurance endowments and savings complaints
products goods*
endowments
2001 2.27 2.53 7.97 0.71 6.35 10.73 28.92 6.73 8.12 25.67 31,347 5.97
2002 1.18 2.95 8.95 0.86 3.71 13.57 33.68 6.60 8.42 20.08 43,330 4.91
2003 1.29 2.58 15.18 1.39 3.82 11.63 21.83 11.13 8.06 23.10 62,170 4.28
2004 0.82 2.15 3.29 1.47 2.79 5.42 53.03 10.85 5.56 14.62 97901 3.31
2005 0.75 2.27 2.70 1.44 2.32 3.80 62.85 7.40 4.06 12.41 110,963 3.35
2006 1.16 3.14 3.49 1.88 2.99 3.59 61.24 5.15 3.69 13.68 112,923 4.78
2007 1.94 8.54 4.63 2.89 4.48 3.91 48.87 3.86 3.96 16.92 94,392 11.24
2008 8.65 31.90 5.54 11.47 4.88 4.30 11.19 2.23 2.61 17.21 123,089 41.12
2009 24.37 10.73 5.96 14.58 4.92 3.88 4.55 4.55 2.76 23.70 127,471 35.80
2010 30.18 15.49 4.58 11.29 3.34 2.20 3.31 3.88 2.58 23.14 163,012 46.34
2011 50.75 9.68 3.43 8.47 2.81 1.31 1.48 1.84 1.61 18.63 206,121 60.94
2012 59.66 5.52 3.61 7.26 2.75 1.31 1.24 1.25 1.58 15.84 264,375 65.82
2013 74.42 3.84 2.34 3.86 1.53 0.86 0.92 0.92 0.64 10.67 508,881 78.62
2014 78.09 3.88 2.46 2.04 1.40 0.85 0.70 0.61 0.48 9.48 512,167 82.49
Average 23.97 7.51 5.30 4.97 3.43 4.81 23.84 4.79 3.87 17.51 175582 32.07
* Including payment protection insurance (PPI), personal current accounts (PCA), card protection insurance, extended warrantee insurance, guaranteed asset
protection, and mobile phone insurance.

26
Table 2: Overdraft and personal current account regulatory treatment
Regulatory Report
Cruickshank report (2001) on
retail banking, Competition
Commission (2002) Small
business banking, and
(Competition Commission
2007a) Northern Ireland
current account reports.
OFT (2008) - investigation as
to the competitive conditions
prevailing within the personal
current account market.
The UK Supreme Court (2009)
judgement as to the fairness of
overdraft charges. A case
brought by the OFT against
the major UK banks. (see
Whittaker 2011)
OFT (2009) investigation into
the personal current account
market
OFT (2010) - investigation as
to the unauthorised overdraft
market
OFT (2011) - investigation as
to the competitive conditions
prevailing within the
unauthorised overdraft market
OFT (2013) evaluated changes
within unsecured overdraft
markets arising from past
regulatory changes.
CMA (2015) examination of
retail banking
Wider examinations of UK
banking (e.g. HM Treasury
2000, the House of Commons
Treasury Committee 2011,
Independent Commission on
Banking 2011).
Notes: FSA - Financial Services Authority; FCA - Financial Conduct Authority; OFT - Office of Fair
Trading; CC - Competition Commission, CMA - Competition and Markets Authority.
Key Conclusions
The reports indicated limited customer switching, high barriers to
entry and complex pricing formats where features of the market.
Enhanced switching procedures and information provision proposed.
The unauthorised overdraft market and the personal current account
market were not working well due a lack of transparency and
complexity in pricing, which concentrated competition on more
visible fees and charges. Proposal to enhance information, switching
and customer awareness. Push for greater regulatory intervention.
The Supreme Court ruled overdraft charges could not be unfair as
they were part of a universal service offered to personal current
account customers. The banks argued contingent charges for
overdraft services are simply part of the payment in exchanges for the
entire package of current account services.
Concerns with pricing complexity, a lack of transparency and
switching persist. Aims to enhance customer awareness of prices and
enhancing switching procedures.
Concerns in this market persist with complexity. It is proposed to
develop working groups with industry and consumer bodies to
develop best practice. Minimum standards to be introduced.
Forwarded initiatives to address switching and improve information.
This report outlined new minimum and best practice standards for
firms supplying overdrafts to be prescribed in the Lending Code.
The costs of using unauthorised overdraft services and the underlying
profitability of these services had fallen by 928m. A focus on
helping consumers control when they use unarranged overdraft
facilities and the charges they incur. Enhanced switching procedures
and improved information provision proposed.
Concerns with the concentrated form of market arise with high
barriers to entry and inert customers persist in this market. A lack of
pricing transparency persists especially in regard to charging
structures. Enhance the customer journey for switching enhancing
prompts to move provider. Improved information delivered through
different media, improve comparison of personal current account
pricing amongst other proposals.
Concerns with the level of competition in this market Have drawn
attention to possible distributional cross subsidies in these markets.
Proposals include the introduction of a seven-day Current Account
Switch Service, a review of account number portability and a
voluntary code to provide free basic bank accounts (accounts with
limited services and without overdrafts).
27
Table 3: Payment Protection Insurance (PPI) regulatory treatment
Regulatory report
Department for Environment,
Transport and the Regions
(2000)
The FSA examined PPI
markets repeatedly since 2005
(FSA 2005, 2006, 2007a, 2007b,
2007c).
The FSA publically censured or
fined 16 firms between 2006 to
2008.
OFT (2006) examined PPI with
lending
CC (2008, 2009) PPI report.
The European Commission
(e.g. 2006) part of the on-going
harmonisation of consumer
protection laws.
Notes: FSA - Financial Services Authority; FCA - Financial Conduct Authority; OFT - Office of Fair
Trading; CC - Competition Commission, CMA - Competition and Markets Authority.
Key finding of the regulatory reports
Reported the need to expand PPI markets to replace the phrasing out
of government provided mortgagee support. Encouragement to
develop the market. Problems with policy quality reported.
Areas investigated include banks selling practices, the provision of
product and price information, the training and competence of sales
staff and the banks internal systems and controls. These issues were
assessed using supervisory investigations and mystery shopping
studies). The firms investigated were selected from all PPI distributors
including retailers, car dealerships, brokers, banks and building
societies. The FSA identified problems with firms which do not sell
financial services as their main line of business. Other persistent
concerns include limited information given to consumers, a lack of
awareness of product exclusions and a failure to indicate the voluntary
nature of PPI. Whilst evidence of pressured selling has been rare, firms
often present the acceptance of both the loan and PPI as the norm
requiring an explicit rejection of PPI by customers.
Public censure and fines of between 14,000 and 7m were imposed
following evidence of assumptive sales techniques where customers
needs where not given sufficient weight, poor information provision
and poor record keeping.
Reported consumers receive poor value from PPI due to a low claims
ratio, and high commissions The issue to be referred to the
Competition Commission for further investigation.
It was ruled joint sales of PPI with loans should be prohibited within
7 days of the loan contract, premiums should be paid through
instalments rather than as a single premium, improved customer
information is required and PPI should be unbundled from other
financial services. Conditions consistent with cross-subsidies from
PPI to lending were present. This resulted in a deadweight loss from
PPI sales of 200m a year with far higher consumer detriment.
Further without cross-subsidies it was predicted the unsecured
lending market would have lost between 1bn and 2bn in 2006.
European credit market concerns include the removal of barriers to
information provision for credit decision making, the form of
interest rate setting and distinct debt collection practices. a European
wide approach for calculating the total consumer cost of credit
including add-on costs such as PPI (European Commission 2006)
should have been included in the national law of member states by
2010
28
Footnotes.

1 A number of abbreviations are employed for regulators and financial services. Throughout FSA refers to
Financial Services Authority; FCA refers to Financial Conduct Authority; OFT refers to Office of Fair
Trading, CC refers to Competition Commission, CMA refers to Competition and Markets Authority and
PPI refers to payment protection insurance.
2 Within the UK, redress paid to compensate customers for inappropriate sales have varied from over

10bn for pensions mis-selling in the 1990s, to 2.8bn for endowment mortgage mis-selling in the 1980s
and 1990s (see Ferran, 2012) to over 14bn paid to customers in redress for mis-sold PPI in the 2000s
(FCA, 2014).
3 The Federal Deposit Insurance Corporation (2008) reported of the 86% of US banks operating overdraft

programmes, half have used external consultants to increase the levels of overdraft interest and maximise
fee income from their customers.
4 Without cross-subsidies from associated PPI sales, it was predicted the unsecured lending market would

have lost between 1bn and 2bn in 2006, generating a deadweight welfare loss on 200m annually
(Competition Commission, 2009). See also Ashton and Hudson (2014).
5 A proportion of the complaints for personal current accounts relate to concerns with ATMs and access

issues as well as overdrafts (these are recorded in the Annual Reports and are low in number).
6 In recent years the UK has observed an increase in packaged personal current accounts requiring regular

access fees and often include additional services used to differentiate personal current accounts (FSA, 2012).

29